Types

• There are two types of loans you can take against your life insurance policy. The first type of loan is a fixed rate loan. A fixed rate of interest is charged against the loan. The second type of loan is a variable rate loan. A variable rate loan interest rate fluctuates and the interest rate is tied to a bond index, typically Moody's bond index.
  
  

Function

• A life insurance policy loan is not a withdrawal of money from the policy. Instead, it is a loan against the value of the policy similar to a loan against a house. Cash values represent equity built up inside of the policy. When you take out a loan, the insurer secures your loan with existing cash values and issues a check to you. Money never leaves the insurance policy. Instead, secured cash values continue to earn normal policy interest crediting rates or earn a reduced interest rate depending on the terms of the loan.
  
  

Benefits

• The benefit of a life insurance policy loan is that no credit check is required. Policy loans are automatically secured using existing cash values. Additionally, loans are tax-free. This means that you won't have to pay taxes on any of the money you receive from the policy unless the policy lapses. Finally, policy loans often receive preferred loan rates. This means that interest rates are far lower than free market interest rates, sometimes zero percent, making life insurance policy loans a very attractive alternative to a commercial loan.
  
  

Disadvantages

• The disadvantages to a life insurance policy loan are that the policy loan decreases the death benefit and available cash values of the policy. This decrease is proportional to the amount of the loan. For example, if you borrow $10,000, a corresponding decrease of available cash values and payable death benefit in the amount of $10,000 will occur.
  
  

Warning

• If your life insurance policy lapses with loans taken out against it, you may have to pay income tax on all of the money you receive. When a policy lapses, all loans are forgiven. If the total loan amount exceeds the total premiums paid into the policy, the amount of cash value in excess of the premiums paid is considered a gain and is subject to income tax.